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Should You Buy NetEase's Resurgence?

The Chinese internet giant can overcome the headwinds it faces.

Investor confidence in NetEase(NASDAQ:NTES) has been low this year. The Chinese internet giant has struggled as its bread-and-butter gaming business has hit a speed bump, while the rapid growth of the e-commerce business is hurting its bottom line. Additionally, the Chinese government's decision to freeze new video game approvals, which is expected to be in effect until early next year, has also slowed the company.

But NetEase's third-quarter results show that it can fight all these odds. The company's top line accelerated impressively thanks to solid growth in online gaming and the e-commerce business. The results were good enough to boost the morale of NetEase investors as they now believe that the company can get back to its winning ways. The company is headed in the right direction, but its path toward growth is still bumpy. Here's why.

Image source: Getty Images.

Online gaming gets back on track

NetEase gets 60% of its total revenue from the online gaming business, so the 27.6% annual growth in this segment was one of the biggest drivers behind the company's impressive growth. But even more impressive was that NetEase managed to do it despite the adverse regulatory environment in China.

The company credits the diversity and longevity of its gaming portfolio. Its flagship titles performed steadily last quarter as the company enriched them with new content, and it will look to build on their popularity with newer iterations. What's more, NetEase's online gaming gross margin increased 260 basis points year over year thanks to the improved contribution from PC client games, which carry a higher margin profile.

Moreover, NetEase's mobile gaming monetization seems to have improved on the back of its expansion into international markets and the popularity of its existing titles. The company's focus on improving the gamer experience with new expansion packs allows it to keep a handle on development costs, as it doesn't have to make new games from scratch. The same applies to the international markets, in which NetEase can localize the content of its existing games.

The only problem is that the online gaming business could be hamstrung because of the Chinese government's regulations. The freeze on new video game licenses led to single-digit growth in the country's gaming market in the first half of 2018. That's a far cry from the 31% growth seen last year. And it won't be surprising to see the pain continue in the short run, as the country is taking longer than expected to implement new licensing procedures.

And in a bid to cut down on childhood myopia, China is also considering a limit on new game licenses that it issues. NetEase's online gaming business could run into some problems because of government regulations. But the company's move into international markets is helping it beat the domestic slowdown, as the latest results show, indicating that NetEase is ready with an alternative to overcome any potential weakness in China.

E-commerce is on a roll

NetEase's e-commerce business has been growing at a terrific pace. Revenue from this segment was up 67% year over year, accounting for just over 26% of the company's total top line. For comparison, NetEase was getting 21% of its total revenue from the e-commerce business a year ago. However, this growth is coming at a cost.

The company's margins in e-commerce are extremely thin compared with the bread-and-butter gaming business. Its e-commerce gross margin stood at just 10% last quarter, versus the 65% for online gaming. This isn't surprising -- e-commerce in China is very competitive, so NetEase is rapidly raising its expenses in this area to grab a greater share of the pie.

Its e-commerce cost of revenue shot up nearly 70% annually in the latest quarter, outpacing the segment's top-line growth. But then, investors shouldn't forget that the Chinese e-commerce market is a $1 trillion opportunity. If NetEase can eke out enough of a share, it should be able to maintain sales growth momentum on the back of higher volumes.

That's the only way NetEase can grow its earnings and beat the thin e-commerce margins, so it is taking steps to boost sales. The company recently struck a deal with a global shipping company to bolster the transportation and logistics of its Kaola e-commerce brand. The company believes that the deal will allow it to reduce delivery times and boost cross-border trade.

This is the latest in a series of steps by NetEase to go after this massive opportunity in China, especially the country's appetite for foreign goods. Kaola has already announced that it will purchase $20 billion worth of foreign goods in the coming years. On top of that, the company is going to increase its warehousing space by 80%, and boost the coverage of its overnight delivery service to 70% of Chinese customers.

A long-term play

There's no doubt that NetEase is sitting on some solid catalysts, but there will be growing pains. The e-commerce business needs to gain enough scale in order to make a meaningful contribution toward NetEase's earnings. Meanwhile, the online gaming business seems to be back on track thanks to overseas growth.

In all, NetEase's earnings power will improve gradually, provided its top line keeps growing at a solid pace, and that's exactly what consensus estimates suggest. The company is expected to clock stronger revenue growth in 2019, which will boost its earnings after a tepid performance this year. That being the case, NetEase is capable of delivering upside and continuing its resurgence despite the headwinds.